[Essay from David] "Price Drives Narrative": Forming Conviction Amid Shifting Sentiments
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The below is an essay written by David.
How is one’s judgment of something not influenced by the “price” of the thing?
As I followed the stock market over the years, I’ve learned a popular phrase: “price drives narrative”. The idea is that the price movement of a stock, rather than the underlying fundamentals of the business, determines investor sentiment and conviction in the stock. I think this slogan carries lessons not just in the stock market, but in life more broadly, including the current political moment.
Price drives narrative works like this. For some reason, usually initially due to a piece of bad news, a company’s stock price begins going down. The narrative often quickly becomes: “We knew this company was vulnerable. They are losing their competitive advantage, and will continue to struggle moving forward.” As the stock keeps falling, fear, uncertainty and doubt take hold, and investors accelerate their selling as all they hear is negative news. This was the case from September 2021 until November 2022 when the price of Facebook declined 75%.
On the flip side, if the price of a stock starts rocketing higher, the narrative becomes: “This is a strong company. We knew they had great products, the concerns were overblown, and the business will continue to grow into the far future.” As the price starts climbing higher, investors accelerate their buying as FOMO takes hold and all they hear is positive news. Since bottoming in November 2022, Facebook’s stock has increased some 600%.
When a stock goes down significantly in a relatively short amount of time, the initial movement is typically based in some real concern, but the excessive movement is usually driven by emotion and sentiment, detached from the underlying fundamentals (reality) of the business.
For example, the initial reason Facebook started to decline in 2021 was because investors were concerned that TikTok was taking younger users, they did not like how much money Facebook was investing in the metaverse, and there was growing regulatory scrutiny of the company. All potentially legitimate reasons to be worried. However, was it reasonable for the stock to decline 75%? No. Maybe 25-30%, sure, but not 75%. Facebook eventually showed that the threat to TikTok was overblown, that they could turn down spending on the metaverse, and that they could cut a large number of employees that were not essential.
The inverse can happen when a stock price begins shooting higher - the initial rise is driven by positive developments, but then is often extrapolated into the far future and ignores the risks of slowing growth and future competition.
Ultimately, when the price of something becomes excessive and detached from the underlying fundamentals - in short, it gets too hyped - it creates a bubble, which eventually pops.
The investor’s job is to understand and form an opinion about the underlying fundamentals of the business and to estimate a reasonable valuation. That’s because although in the short term the price of a stock is often driven by narrative and momentum, in the long run it is determined by the profit growth of the business, not feelings. In other words, it has to produce evidence that it is a good business. Apple’s stock has not increased 200,000%+ over its history as a public company because investors kept believing in it without evidence. Rather, it continued to sell products to millions of more people every year and produce huge amounts of cash. That’s why investors love it.
A thing has staying power (longevity) if it is true. In this case by true I simply mean there is something real at the bottom (evidence in reality).
What is the lesson in all of this and how does it apply to things outside the stock market?
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